What are cryptocurrencies?

Cryptocurrencies, also known as virtual currencies or digital
currencies, are a form of electronic money. They do not physically
exist as coins or notes. A cryptocurrency unit, such as a bitcoin
or ether, is a digital token created from code using an encrypted
string of data blocks, known as a blockchain. There are usually
only a fixed number of digital currency tokens available.

Cryptocurrencies are not only used as payment systems but can
also be used to execute contracts and run programs. Anyone can
create a digital currency, so at any given time there can be
hundreds, or even thousands, of cryptocurrencies in
circulation.

Virtual currencies can be bought or sold on an exchange platform
using conventional money. Some popular digital currencies, like
Bitcoin can be bought or sold for cash through special ATMs.

How cryptocurrencies work

Digital currencies use blockchain technology. A blockchain is
simply a decentralised database that all users share. There is no
central server and nobody owns the data but everyone in the
blockchain has access to all the data in the blockchain.

Users earn or create blocks (units) in a digital currency by
solving complex cryptographic puzzles and verifying transactions,
also known as mining. This is a difficult process that requires
significant computing power. Blocks are then added to a blockchain
where they can be used for electronic peer-to-peer payments. The
blockchain tracks ownership of each currency unit and holds a
history of every transaction ever made on the blockchain.

Digital wallets

Cryptocurrencies are kept in a digital wallet and can be used to
pay for actual goods and services from any person willing to accept
them as payment. However, they are not legal tender and may not be
accepted in many places. Digital currency payments are made online,
but some merchants can accept payments in store using mobile
devices. Cryptocurrency networks generally have no or low
transaction fees.

Popular with criminals

The relatively anonymous nature of digital currencies has made
them very attractive to criminals, who may use them for money
laundering and other illegal activities. Digital currencies are a
popular choice of payment for transactions conducted on the dark
web.

Types
of cryptocurrencies

Each cryptocurrency has different capabilities depending on the
purpose for which it was developed. Although digital currencies
have been traded for profit, most were not created as investment
vehicles.

Bitcoin

Bitcoin is primarily a digital currency. Users in the Bitcoin
network, known as bitcoin miners, use computer-intensive software
to validate transactions that pass through the network, earning new
bitcoins in the process. Bitcoin was developed as a decentralised
global payment system; however, it has also been bought and sold in
large volumes as a speculative investment.

Ethereum

Ethereum uses blockchain technology to run an open software
platform. It can process transactions, contracts and run other
programs, which allow developers to create and run any program, in
any programming language, on a single decentralised platform.

In the Ethereum blockchain, miners work to earn ether, which is
the crypto token that drives the network. Ether can also be used to
pay for fees and services within the network.

Litecoin

Litecoin, like Bitcoin, was created as an electronic payment
system; however, transactions on the Litecoin network are processed
faster and there are more litecoins in circulation than there are
bitcoins. Some users see Litecoin as a 'lighter' version of, or
backup for, Bitcoin.

Ripple

Ripple is a transaction protocol designed to complement Bitcoin
by allowing real-time transfers between users in any
currency. It is a database in which users can store and
transfer value in any currency, including other cryptocurrencies,
on a protected network.

Ripple uses tokens that were created by the developers, rather
than mined or earned like other digital currencies. Some users
don't see Ripple as a true cryptocurrency, but the technology has
been popular with financial institutions.

The risks of investing in
cryptocurrencies

Fewer
safeguards

The exchange platforms on which you buy and sell digital
currencies are not regulated, so if the platform fails or is
hacked, you will not be protected and will have no legal recourse.
Cryptocurrency failures in the past have lost investors significant
amounts of real money. In most countries cryptocurrencies are
not recognised as legal tender and are only regulated to the extent
that they fit within existing laws, such as tax laws.

Values fluctuate

A cryptocurrency is not guaranteed by any bank or government.
Its value is based on its popularity at a given time, which is
influenced by factors such as the number of people using it, the
ease with which it can be traded or used and the perceived value of
the currency and its underlying blockchain technology. Investing in
virtual currencies is considered highly speculative, as values can
fluctuate significantly over short periods of time.

Your money could be stolen

Just as your real wallet can be stolen by a thief, the contents
of your digital wallet can be stolen by a computer hacker.

Your digital wallet has a public key and a private key, like a
password or a PIN. However, digital currency systems allow users to
remain relatively anonymous and there is no central data bank. If
hackers steal your digital currency you have little hope of getting
it back.

You also have no protection against unauthorised or incorrect
debits from your digital wallet.

How cryptocurrency is taxed
in Australia

If the cost of your digital currency is less than $10,000 and
you are only using it to pay for personal goods or services, it is
not taxed. However, according to the Australian Taxation Office
(ATO), if you are using virtual currencies, such as bitcoins, for
other purposes, you will be taxed. Here is an outline of the ATO's
proposed tax treatment of crypto-currencies:

Investment - If you hold digital currencies as
an investment you will pay capital gains tax on any profits when
you sell them.

Trading - If you trade virtual currencies for
profit, the profits will form part of your assessable income.

Carrying on a business - If you use
cryptocurrencies to pay for (or accept them as payment for) goods
or services, the transactions will be subject to goods and services
tax (GST).

Mining bitcoin - If you are mining bitcoins or
other digital currencies, any profits you make will be included in
your assessable income.

Conducting an exchange - If you are buying and
selling cryptocurrencies as an exchange service you will pay income
tax on the profits and transactions will be subject to GST.